Banks: The New Safe Haven?

Are bank stocks back? Maybe. Just looking at recent performance from some of the financial sector’s biggest names, it’s hard to argue that banks aren’t on the rebound.

The Financial Select Sector SPDR ETF (NYSE:XLF) is up 14% since Jan. 1. JPMorgan Chase (NYSE:JPM) is up 22%. Citigroup (NYSE:C) is up 30%. Bank of America (NYSE:BAC) is up 43%.

What’s more: On Thursday, March 15, the Federal Reserve will announce the results of its latest “stress tests” on banks — and decide which major financial institutions are in good enough shape to increase their dividends. Considering that JPMorgan already boasts a healthy 2.4% dividend yield, this could make some financial stocks serious players among income investors once more.

But as the old saying goes, past performance is no guarantee of future returns. So before investors go jumping into bank stocks, they should take a hard look at the risks and rewards of the financial sector.

In fact, the question isn’t whether banks are safe stocks, since all equities pose a substantial level of risk right now. A better question is whether banks are safe enough for your specific investment strategy. After all, persistently high unemployment, debt woes in Europe and Washington and fears of a slowdown in China are just a few macroeconomic challenges that could take the wind out of any sector — and financials are no different.

Only you can decide whether the risks outweigh the rewards. But to help you make that decision, here are the five biggest problems and the five biggest opportunities facing big financial stocks right now:

Risks to Big Bank Stocks

New Capital Requirements Limit Banks: At the core of most uncertainty is the recent regulatory push. Global banking safeguards regarding higher levels of capital reserves (so-called “Basel 2″ and “Basel 3″ rules) force financial institutions to hold a larger amount of cash on the balance sheet — preventing them from actively using that money to grow profits via lending or investing. It also has to be “high-quality” capital, not just paper and IOUs, in the event that another economic shock forces banks to tap into that cash. Whether this is a needed move for global banking stability or an overreach of regulators is academic — when these safeguards roll out in the years ahead with a full implementation deadline of 2015, you can understand how they will create a drag on earnings.

Volcker Rule: Equally troublesome for banks is a ban on proprietary trading (the so-called “Volcker Rule”) so companies can’t play the market with house money. Consider that in Q2 of 2009, Bank of America raked in a cool $6.7 billion in just three months from its trading operations. Under strict interpretation of the proposed ban on trading, not a penny of those profits would have existed. When you back out billions in trading revenue from bank earnings — especially while consumer and business lending remains anemic — it creates rather unimpressive numbers for major financial stocks.

Mortgage and Sovereign Debt Losses: Bad debt from eurozone debt and troubled American mortgages remains a weight on earnings. U.S. banks’ direct exposure to European sovereigns is around $100 billion, according to reports. Then there’s the tens of billions of dollars that banks are taking to settle foreclosure lawsuits and write down foreclosures and bad debt that lingers on the books. Many banks have delayed writedowns to their loan portfolios, and still are listing some debts at full value — which is willfully naïve. Once they formally record the losses, investors might be in for an ugly surprise. Bank-owned homes are a similar problem, since the market value of these homes is sure to be vastly different than what the folks in accounting are valuing the properties at.

Interbank Faith and Confidence: Back to the European debt woes. Things have improved recently on hopes of a restructuring that will help Greece avoid default, but we aren’t out of the woods. A shock to the system could freeze up the credit markets and threaten to sink troubled banks without much cushion on their balance sheets. All the talk about “contagion” is based on the idea that once banks suffer a crisis of confidence, the panic quickly spreads worldwide. If Greek banks can’t get loans and fail, so does the Greek economy. If the Greek economy fails, other banks will suffer in kind. Then they can’t get loans, and the cycle continues. Lehman Brothers went down because of such a global credit freeze, and we should be wary of similar events occurring again. No matter what share prices have done recently, some major U.S. banks likely would be in dire straits if their interbank loans disappeared unexpectedly.

Populist Backlash: Not for decades have we seen such hatred of the biggest bankers. Consider the recent rise of credit unions and loss of customers at major financial institutions as people get fed up with hidden fees and remain angry about the “too big to fail” bailouts of a few years ago. Occupy Wall Street is hardly a substantive political movement, but it echoes the frustrations of a nation that thinks bankers are part of the problem and not part of the solution. That makes it difficult for lenders to grow their business and make the pitch for looser regulations that allow them access to greater profits.

Opportunities in Big Bank Stocks

Now that we have the ugliness out of the way, we can take an honest look at the possibilities that big banking stocks hold. The financial sector really is no different than any other in that investors must be smart about their money to minimize risk and maximize potential for profits.

So with all those risks fully disclosed, here are factors favoring financial stocks right now:

Prospect of Income: Back to the upcoming Thursday reports: A number of financial companies have petitioned the Federal Reserve for substantive increases to their dividends. And if granted, that would be a huge plus for investors. Take Wells Fargo(NYSE:WFC), which pays just 12 cents — half the 24 cents per quarter it paid in 2005, even though share prices are higher than they were seven years ago. Granted, a lot has changed. But there are reasons to be hopeful that some stocks could see a significant increase to their payouts this week, which would make these picks more attractive.

Passing the Test: Furthermore, if the Fed signs off on higher dividend increases, then you can assume the companies granted this approval have proven their stability. It’s silly to think this means banks are a good buy based on this endorsement alone — but it’s encouraging to know regulators see signs of improvement in the big financial stocks. Conspiracy theorists would argue that these moves mean nothing, but an equally cynical point to counter that is the fact that sentiment drives stocks more than fact. If most folks believe the stocks are safe, shares will rise — and investors will profit regardless. Of course, any bank that fails the “stress test” is going to be in for it …

Broader Economic Recovery: Warren Buffett famously said, in the depths of recession, that “It’s never paid to bet against America. We come through things, but its not always a smooth ride.” Why else do you think the Oracle of Omaha has invested heavily in banking stocks over the last few years — from WFC to preferred shares of Bank of America? Because he believes the economy eventually will turn around, and banks naturally will prosper from increased lending to businesses and consumers. Whether that rebound will be a clear surge or a slow trickle remains to be seen, and whether the recovery is happening now or will be delayed a year or two or is up for debate. But if you believe America’s economy eventually will be up and running in world-class fashion, it behooves you to buy bank stocks before that recovery takes shape.

The Smart Money Is Buying: Think Buffett is alone in his support of banks? Well, Dick Bove, an acclaimed financial sector analyst at Rochdale Sector, has been banging the table on bank stocks for months. In December, Bove said that “2012 has every indication for being a gangbuster year in terms of earnings, market share, loan growth, deposit inflows, liquidity, capital growth,” and that investors should dive into the sector even if they have to “hold their nose” while they do it. Whitney Tilson, founder of money management firm T2 Partners, said a similar thing a few weeks before Bove. In short, the “smart money” already has started hunting around the financial sector. If you don’t want to be late to this trend, it’s time you did too.

Not All Banks are Equal: It’s important to remember that being bullish on a bank stock or two doesn’t mean you believe every single financial stock will thrive. Some are undoubtedly better than others. Maybe you have a small, regional bank that you’ve been watching that has outperformed. Or maybe it’s a midsized bank like Capital One (NYSE:COF), which had the resources to pull off a bargain buyout of ING Direct for roughly $9 billion that will juice its growth potential in the years ahead. Phillip van Doorn picked COF as his Best Stock for 2012 in our stock-picking contest, and he’s sitting on almost 20% gains since Jan. 1!

The point is: Do your own research and think critically about individual banks. The sector has moved in lockstep for a while, but very soon the good banks will be able to move independently of the bad. Make sure you are in the right investments to profit in 2012.